Earnings Call Transcript - KC Q3 2022

Operator, Operator

Thank you for joining us, and welcome to the Kingsoft Cloud Holdings Third Quarter 2022 Earnings Conference Call. All participants are in listen-only mode. There will be a presentation followed by a question-and-answer session. I will now turn the conference over to Ms. Nicole Shan, IR Manager. Please proceed.

Nicole Shan, IR Manager

Thank you, operator. Hello, everyone, and thank you for joining us today. Kingsoft Cloud's third quarter 2022 earnings release was distributed earlier today and is available on our IR website at ir.ksyun.com, as well as on GlobeNewswire services. On the call today from Kingsoft Cloud, we have our Vice Chairman and the CEO, Mr. Tao Zou; and the CFO, Mr. Haijian He. Mr. Zou will review our business strategies, operations and the company highlights, followed by Mr. He, who will discuss the financials and the guidance. They will be available to answer your questions during the Q&A session that follows. There will be consecutive interpretations. Our interpretations are for your convenience and reference purpose only. In case of any discrepancy, management's statement in the original language will prevail. Before we begin, I would like to remind you that this conference call contains forward-looking statements within the meaning of Section 21-E of the Securities Exchange Act of 1934 as amended and as defined in the U.S. Private Securities Litigation Reform Act of 1995. These forward-looking statements are based upon management's current expectations and current market and operating conditions and relate to events that involve known or unknown risks, uncertainties and other factors, all of which are difficult to predict and many of which are beyond the company's control, which may cause the company's actual results, performance or achievements to differ materially from those in the forward-looking statements. Further information regarding these and other risks, uncertainties or factors are included in the company's filings with the U.S. SEC. The company does not undertake any obligation to update any forward-looking statements as a result of new information, future events or otherwise, except as required under applicable law. Finally, please note that unless otherwise stated, all financial figures mentioned during this conference call are denominated in RMB. It's now my pleasure to introduce our Vice Chairman and CEO, Mr. Tao Zou. Please go ahead. Thank you.

Tao Zou, CEO

Hello, everyone. Thank you for joining Kingsoft Cloud’s third quarter 2022 earnings call. Since becoming CEO in August, I have led a thorough review of our strategy, business, and finances. In this quarter, we implemented various initiatives effectively. We continued investing in technology, focused on our core businesses, and revised our vision for cloud services. We also reviewed and assessed our customer base and project portfolio, strengthened cost control, and aimed for better revenue growth and profitability balance. At the same time, we enhanced our ecosystem synergies, explored high-value opportunities, and pursued high-quality development. Our financial performance was solid this quarter, with total revenues of RMB1.97 billion, aligning with our guidance. The adjusted gross margin improved significantly to 6.3% from 3.6% in the previous quarter. Our operating cash flow has been positive for two consecutive quarters, showing that our business adjustments and cost control efforts are starting to show results. We remain committed to building success through technology and are focusing on developing key product capabilities in the IF and SaaS layers. These efforts were acknowledged by Frost & Sullivan, which recognized Kingsoft Cloud's data management solutions as leaders in the market for innovation and growth performance in their recent report. Additionally, IDC's latest tracking of China's software-defined storage ranked our enterprise-level storage solution, King storage, among the top four in the software-defined object storage market. Regarding ecosystem collaboration, we improved our technological partnership with Kingsoft Office for enhanced cloud document processing, including authentication, encryption, and proofreading. By utilizing our cloud computing capabilities, we helped Kingsoft Office improve their business logic layer for processing, enhancing the end-user experience. We continue to focus on our key industry verticals by replicating successful projects for customers in their respective sectors. In public services, we developed a smart cloud solution for municipalities using our hybrid cloud and distributed storage technology to support the management of economic affairs effectively. In the financial services sector, we showcased our data governance capabilities, particularly in data lake and metadata management for major commercial banks, and we plan to replicate this success with more clients. In healthcare, we are nearing completion of capacity expansion projects for medical image clouds in regions like Sichuan and Chongqing, reinforcing our commitment to meeting customer needs as they upgrade their existing projects. Overall, we will keep investing in technology, concentrating on core businesses, and strengthening our foundation to enable sustainable, high-quality development. Amid the digitalization wave, we aim to penetrate key strategic verticals and provide our customers with safe, robust, and efficient cloud computing services. I will now hand the call over to our CFO, Haijian, to discuss our financials for the quarter. Thank you.

Haijian He, CFO

Thank you, Tao Zou, and welcome, everyone for joining the call. Now I will walk you through the financial results for the third quarter 2022. We have actively taken measures to improve efficiency, demonstrating our strong commitment to pave the path for profitability. This quarter, our adjusted gross margin has improved considerably and continuously from the lowest point of 1.2% in the fourth quarter of 2022, to 3.6% in the second quarter this year and further to 6.3% in the third quarter. Our operating cash flow has been positive for the past two quarters consecutively, and we have achieved RMB100.9 million net operating cash flow this quarter. Our total revenue was RMB1,968.8 million in Q3. Within that, revenues from public cloud services were RMB1,349.0 million. While increased by 4.4% compared with Q2, it represents a 20.2% decrease compared to the same period in 2021. The change was primarily due to the company's proactive scaling down of the CDN business, with its gross billing decreasing by about 28% on a year-over-year basis. Revenues from enterprise cloud services were RMB622.0 million, which is relatively stable compared with Q2 2022 as we navigated a challenging operating environment, including the impact from the resurgence of COVID-19 in China. While proactively applying more selective criteria to project screening to strive for better profitability and cash flow. Our cost-saving measures are well on track within our plan. Total cost of revenues decreased by 20.6% year-over-year and remained stable quarter-to-quarter at RMB1,846.4 million. IDC costs decreased significantly by 23.6% year-over-year from RMB1,410.9 million to RMB1,087.3 million this quarter. Depreciation and amortization costs increased by 26.9% from RMB200 million in the same period of last year to RMB253.7 million, while remained stable compared to last quarter. It is in line with our revenue mix adjustments as we moderated the procurement process of service for public cloud. Solution development and services costs increased from RMB160 million to RMB443.1 million this quarter. The increase was mainly due to the consolidation of Camelot since September last year. Fulfillment costs and other costs were RMB31.9 million and RMB39.3 million this quarter. The adjusted gross profit of this quarter was RMB124.7 million, representing an adjusted gross margin of 6.3%. The significant gross margin improvement was mainly due to the effect of cost control measures and strategic adjustments of our revenue mix. In terms of expenses excluding share-based compensation, total adjusted operating expenses were RMB577 million. Within that, adjusted R&D expenses were RMB231.6 million, an increase from RMB190.8 million from last quarter as we remain focused on our technology development. Adjusted selling and marketing expenses were RMB125.5 million compared with RMB120.1 million last quarter. Adjusted G&A expenses increased slightly from RMB196.0 million last quarter to RMB219.9 million, which is partially due to one-time expenses of the Hong Kong listing projects. Net loss margin was 40.7% this quarter and adjusted net loss margin was 24.8%. The adjustment was mainly due to the foreign exchange loss of RMB218.9 million, caused by the significant fluctuation of U.S. dollar RMB exchange rates, which is a totally non-cash item impact on the P&L items. As of September 30, 2022, our cash and cash equivalents and short-term investments amounted to RMB5.3 billion, providing us sufficient liquidity for operations. The capital expenditures for the quarter were RMB253.3 million, which primarily consisted of payment for services which we ordered previously. The decrease of CapEx was in line with our proactive scaling down of the CDN business. We expect to keep our total CapEx within RMB1.5 billion for the full year of 2022. In terms of share repurchase program, regarding our $100 million share repurchase program within a 12-month period as approved by the Board and announced in March this year, we have been duly executing since the release of our Q2 earnings results up to November 18; we bought a total of 10.41 million ADS shares for roughly about $23.92 million. Going forward, supported by our ample cash reserve of about RMB5.3 billion, we expect to continue to execute from time to time with a way to mandated repurchase program. These efforts fully demonstrate our Board and management's strong commitment and full confidence in the long-term business prospects of the company. As we strive to reward our shareholders for their support, we believe our share price will eventually reflect the company's true value. Finally, we submitted the application for Hong Kong's dual primary listing on July 27, 2022. As always, the listing and the potential timing is subject to regulatory approvals. Looking ahead, although we are still implementing our strategy initiatives, including business repositioning and cost control efforts on an ongoing basis, such adjustments have already yielded positive preliminary results as reflected in the clear improvement of the profit margin in Q3. We expect our total revenue to be between RMB2 billion and RMB2.2 billion for the fourth quarter of 2022, representing a quarter-over-quarter increase of 1.6% to 11.7%. While these forecasts and comments above are based on our current and preliminary views of the market and operational environment, which are subject to change, we firmly believe that given the time, the effects of our ongoing strategic initiatives will continue to amplify and reflect our financials in the mid to long-term. Thank you.

Nicole Shan, IR Manager

Thank you. This concludes our prepared remarks. Thanks for your attention. And we are now happy to take your questions. Please ask your questions in both Chinese Mandarin and English, if possible. Operator, please go ahead. Thank you.

Operator, Operator

Thank you. Your first question today comes from Thomas Chong with Jefferies. Please go ahead.

Thomas Chong, Analyst

Thank you, management, for addressing my questions. My first question is about the recent COVID outbreak and the uncertainties in the macro environment. How should we approach the immediate future as well as the 2023 outlook during our budgeting process? Additionally, could management provide comments on the trends for public and enterprise cloud in relation to the Q4 revenue guidance? Thank you.

Tao Zou, CEO

Thank you, Thomas. In response to your second question about Q4, we expect a recovery in our top-line growth, starting from last quarter and continuing through this quarter and into Q4. We anticipate total revenue will show an upward trend in Q4. Regarding our strategic adjustments in the CDN business, with the initiatives nearly completed, we have established a stable foundation to project public cloud revenue in Q4. As a result, we expect to see a slight sequential improvement in public cloud revenue with continued positive contributions to our overall gross margin in Q4. On the enterprise cloud side, reflecting on Q1, Q2, and the current quarter, some delays in project bidding and execution were caused by COVID measures in Beijing around April to July. In Q3, we focused on accelerating deployment, and we hope that some major projects, like the healthcare cloud initiative, can be executed and recognized in Q4, contributing to the revenue. Therefore, we anticipate a modest increase in enterprise cloud revenue as part of our overall revenue. Our key priorities remain the sequential improvement in both revenue and gross margin, while we also need to maintain our expense control. We're hopeful that the measures we've implemented will yield benefits in Q4 and into next year. It will take some time, but we believe we are on the right track to see those benefits emerge. Thank you, Thomas.

Haijian He, CFO

Thank you. And I think it's just a quick translation of what Mr. Zou responded to the first question. The COVID situation has been going on for years. And honestly speaking, it has been impacting the overall society significantly across all verticals, including us. And like you rightly pointed out, we are also observing and trying to see what the next step might be. As you might be aware, in recent days and weeks, the situation in Beijing is becoming more severe; to abide by the government rules, we have only 20% of the workforce currently working in the office. As you know, there has been one situation like this back in April and May. So it's really difficult to predict or comment on the situation. What we can do is to abide by the rules promulgated by the government. However, I think from a strategy perspective, in light of the uncertainty and potential uncertainty in future years, we will maintain a robust and relatively defensive approach. And what I mean by that is exactly what we commented in the prepared remarks, which is no longer blindly pursuing top line growth but switching to pursuing sustainability and a path to profitability. As you have seen, the gross margin in the third quarter has already improved quite a lot from 3.6% to 6.3%. So we believe that by abiding by that relatively conservative and robust strategy, we'll be able to navigate through the potential uncertainties in the years to come. As to your question about our budgeting, we are currently going through the process of making a comprehensive budgeting, currently going through the first round of review and compiling the numbers. We expect to have more clarity towards the end of December or the beginning of January. So unfortunately, we don't have much more data to share at this stage. Thank you.

Thomas Chong, Analyst

Thank you.

Operator, Operator

Your next question comes from Xiaodan Zhang with CICC. Please go ahead.

Xiaodan Zhang, Analyst

So my first question is about our non-GAAP EBITDA margin, which saw a slight decline quarter-over-quarter in Q3. Do you anticipate any delays regarding the timing for achieving breakeven on the non-GAAP EBITDA margin? Additionally, what is our capital expenditure plan for the next two to three years? Are there any plans to extend the useful life, similar to how some of our international peers have extended it from four to six years? Thank you.

Haijian He, CFO

Thank you. This is Henry. Happy to take all those three questions on the financial-related matters. The first question is regarding the EBITDA breakeven. We do acknowledge that the EBITDA on a sequential basis actually dropped a little bit marginally. We noted that there are a few things on the line. First of all, if you look at the total expenses on the dollar value, actually, our sales, marketing and R&D expenses were quite stable, so there were no major changes on that. However, the booking of certain G&A expenses due to, for example, the Hong Kong dual primary listing projects, that we actually need to pay certain fees, as you may understand, that were also eating up the bills as well. And also given this year, we do have certain cost-cutting, for example, the optimization of human capitals of the company; we need to pay certain compensations for the people who may choose other career tracks. We did a batch of those arrangements in Q3, especially towards the end of Q3. So the savings on the salary have not been reflected in expenses in Q3, while we needed to pay even more for the compensation for the people that they chose other career tracks. So in and out, you'll see actually the fluctuation and even increasing on certain expense items. But I think these are the right things to do for the company and the benefits on the cost of savings and expenses will be gradually released in Q3, and I think for some time down from Q1 next year. So that's quite clear on the online reasons. We don’t worry too much about that little fluctuation, but the normalized operational expenses in Q3 already declined. Given that, as you probably know, our priority at this moment is improving the gross margin. As we mentioned, the gross margin has been improving from almost only 1% last Q4, last year, to about 6.3% this quarter. That's a meaningful improvement. And if you look at the growth profit on a dollar value, we almost doubled from Q2 to Q3 from about RMB50 million to about RMB120 million for this quarter. So we believe the improvement on the gross margin will be a first-level driver of improving EBITDA and even breakeven of EBITDA timing. So given that, we think sometime next year, we do hope the EBITDA margin will improve at a little bit faster pace compared with the gross margin sometime during next year. On the other side, we do hope that after we complete all the necessary capital market transactions, our expenses ratio will further come down as well. So that's the first point. The second point regarding the CapEx plan: I think this year, we're running relatively well, at the low end of the capital budget for 2022, while we print the same level of revenue target, which is a good sign. For the next two to three years, I think we may keep relatively the same level at around RMB1 billion each year. You may remember we discussed that we may need to hit a certain server replacement cycle, sometime around '25, '26. So far, we feel comfortable with around RMB1 billion on capital expenditures. But given we do have about RMB5 billion cash, and right now we have multiple access to capital, not only from the stock market but also long-term financing and inexpensive leasing arrangements. So we do hope over 90% of the capital expenditures we may find other ways to fund those capital expenditures outlay rather than tapping to our own net cash balance. I think that's a good point on the capital structure, and we don't need to burn too much cash on hand. The third question is regarding the service: you are right, we do notice that the major U.S. cloud companies have revised their depreciation policy from four years to five years, last year, and some of them are discussing the shift to six years, which reflects the nature of the technology as they evolve because most of the new servers starting from these two years, for example, some of the expensive ones, although the price point is high, they can actually use like three to four times longer life cycles. So it does make sense for the U.S. peers to extend that. But given we adopt a very conservative financial policy, we do not have any plan at this moment to extend our depreciation policy, even though we understand that extending it from four years to five or six years would have a good impact on the gross margin because we would have lower G&A expenses. But at this moment, we do not have any plan to revise that policy. We may reserve that if we see other Chinese players change their policy. It's going to be an uplift to our gross margin and reduce the depreciation and amortization expenses. Thank you.

Xiaodan Zhang, Analyst

Thank you. That’s very helpful.

Operator, Operator

The next question comes from Joel Ying with Nomura. Please go ahead.

Joel Ying, Analyst

I would like to discuss margin improvement. Can management explain the origins of this improvement, specifically in relation to public cloud and enterprise cloud, and whether it will be sustainable in the first quarter and beyond? Thank you.

Haijian He, CFO

Thank you, Joel. Yeah. On the gross profit margin, you touched upon a few things: the improvements, the breakdown, the root causes, and the sustainability. It's a very broad scope actually. I think I'll start with the reasons first, so there are a few things we actually started to work on since Q4 last year, so it's not actually happening only this quarter. There are a few things involved. As you may remember, first of all, we’re cutting some losses for certain loss-making clients. Number two, we optimize the product mix, right? So we try to make computing, storage, some of the big data solutions and certain more high-value-added products more profitable. We invested a bit more, right? So I think these are the second reason. We started to do that from Q1 this year. And the third reason is the improvement and the screening of the projects. As Tao Zou mentioned in the CEO remarks, we actually, starting from this quarter, have adopted a very comprehensive approach to analyze returns on each projects and different ratings internally for different clients, etc. So we can prioritize and select the right projects we're working on, and some of that has already yielded good results for this quarter as well. And the last reason is actually, if you remember last year, we kind of learned our experience and the lessons. We ordered a bit too much of the service, and we ordered a bit too much of the bandwidth that cannot be returned. So that was eating up the gross margin last year, especially in the second half. So this year, we have changed our process to evaluate the procurement process to make sure that we do not over-order it and we can use them wisely. So I think these are the four different things that helped the gross margin improve for this quarter to see the results. Even though we did something last year, it's a good time to see the results. Speaking about the mix, I think that both public cloud and enterprise cloud have contributed to the incremental RMB60 million of the margin improvement. As you know, given the base of the public cloud and enterprise cloud is actually quite balanced, and we cannot lose any of that. So it's both important. And on the sustainability, I think the first three reasons, as I mentioned, we will carry a long way. So you will see, hopefully, a better margin in Q4, and some time carry over to next year as well. Certain enterprise cloud projects, as you know, we are booking the revenue only at completion, but some of the costs we already booked. So hopefully, in Q4 as a peak time of enterprise cloud delivery, you will see additional step-up on enterprise cloud contribution. So if you want to break down the reason for Q4 going forward, I think enterprise cloud will be relatively more important than public cloud in Q4 given the timing and delivery on that. Thank you, Joel.

Joel Ying, Analyst

Thank you, Henry.

Operator, Operator

The next question comes from Timothy Zhao with Goldman Sachs. Please go ahead.

Timothy Zhao, Analyst

Thank you, management, for addressing my question. I'd like to inquire about the outlook for 2023, considering this year serves as a transition period for our business adjustments, alongside the effects of the macro environment and COVID. Could management provide insights on how we should assess the demand in the overall cloud industry in China? Additionally, when can we expect to see a turning point in our cloud revenue growth in 2023? Thank you.

Tao Zou, CEO

Okay. In response to your question, we're currently in the early stages of budgeting for next year and do not have a complete overview to share until the end of this year. However, I can discuss some macro insights and our strategic response. Given the changing circumstances and control measures in China, we are shifting our focus from revenue growth to profitability, a trend observed across the sectors. There is still considerable uncertainty regarding future COVID control measures and the country’s economic planning after the 2023 sessions, prompting us to adopt a conservative and defensive approach. As part of this strategy, we will exit unprofitable projects and customers. We'll also reassess our customer base, especially as larger customers have historically dominated revenue contributions, affecting our financial performance. We may reduce that contribution and seek to increase revenue from smaller customers. Additionally, in enterprise cloud services, we will continue to focus on strategically chosen verticals while cautiously exploring new, promising sectors like the electric vehicle industry. Those are my thoughts on the macro situation. Thank you.

Haijian He, CFO

Yes. Thank you, Timothy. I also want to add one point as well: while we follow the market and client demands carefully, and while we are looking for, as you do as well, for the next kind of acceleration or the v-shape acceleration of the demand from clients, we have a capacity on the cash reserve as well. As you can see, we already delivered a net positive on operating cash flow side this quarter. Hopefully for next quarter and going forward, we can continue to do that. We remain relatively robust on the cash balance, and while we're investing carefully in the potential new verticals that will carry relatively faster growth, as Tao Zou mentioned, for example, the new energy EV cars and other verticals as well. So I think we do not worry too much about the timing because we have enough cash, and we can wait for the market to come back and work with the right clients. So I think that's actually one more point I just want to say as well. Thank you.

Timothy Zhao, Analyst

Thank you, guys. Very helpful.

Operator, Operator

There are no further questions at this time. I will now hand the call back to Ms. Shan for any closing remarks.

Nicole Shan, IR Manager

Thank you, operator. Thank you all once again for joining us today. If you have any further questions, please feel free to contact us. Look forward to speaking with you again next quarter. Have a nice day. Good-bye.

Operator, Operator

This does conclude our conference for today. Thank you for participating. You may now disconnect.